Research

We find strong empirical evidence that the liquidity yield on government bonds in combination with standard economic fundamentals can well account for nominal exchange rate movements. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all the G10 countries, and we stress that the U.S. dollar is not special in this relationship. We show how these relationships arise out of a canonical two-country New Keynesian model with liquidity returns. Additionally, we find a role for sovereign default risk and currency swap market frictions.

Recent research has found that the Taylor-rule fundamentals have power to forecast changes in U.S. dollar exchange rates out of sample. Our work casts some doubt on that claim. However, we find strong evidence of a related in-sample anomaly. When we include U.S. inflation in the well-known uncovered interest parity regression of the change in the exchange rate on the interest-rate differential, we find that the inflation variable is highly significant and the interest-rate differential is not. Specifically, high U.S. inflation in one month forecasts dollar appreciation in the subsequent month. We introduce a model in which a Taylor rule determines monetary policy, but in which not only monetary shocks but also liquidity shocks drive nominal interest rates. This model can potentially account for the empirical findings.

This paper studies the interaction between foreign exchange reserves and the currency composition of sovereign debt in emerging countries. Focusing on inflation targeting countries, we find that holdings of foreign reserves are associated with higher local currency sovereign debt, an exchange rate which is less sensitive to global shocks, and a lower exchange rate risk premium in local currency sovereign spreads. We rationalize these findings within a financially constrained model of a small open economy. The Sovereign values local currency debt as a hedge against endowment risk, but since the exchange rate tends to depreciate in times of global downturns, risk averse international investors charge an additional currency risk premium on this debt. When a country optimally uses foreign reserves to lean against the wind in response to global shocks, this dampens the response of the exchange rate, providing insurance for the global investor. By reducing the risk premium on local currency debt, foreign exchange reserves therefore facilitate a higher share of local currency debt in the sovereign portfolio. Quantitatively, we find the welfare benefits for the sovereign from optimal foreign reserves management can be very large.

Using a two-country model, this paper shows that the shift from foreign currency to local currency external borrowing does not eliminate the vulnerability of EMs to foreign financial shocks but instead results in “original sin redux”. A monetary tightening abroad is propagated to EM financial conditions through a tightening of foreign lenders’ financial constraints, driven in part by currency mismatches on their balance sheets. Foreign exchange intervention and capital flow management measures can mitigate global financial spillovers to EMs in the short run and a larger domestic investor base can reduce the vulnerability in the longer run.

Corporate external debt in emerging countries is very dollarized. We show this could create an externality to the sovereign and is reflected in sovereign spreads. Empirically, decomposing sovereign spreads into their credit default premium (default probability) and credit risk premium components, an increase in foreign-currency corporate debt is associated with a significant increase in the sovereign risk premium but does not change the sovereign default premium. We reconcile both findings in a quantitative model with risk-averse international investors, foreign-currency corporate debt makes the sovereign more likely to default in investors’ bad times when foreign-currency appreciates, thus increases the risk premium.

Using firm-level data from emerging markets, we examine the effect of US dollar debt issuance on corporate risk-taking in the low-interest-rate environment after the global financial crisis. We find that the dollar debt issuance significantly increases issuers’ risk-taking. This effect is more pronounced when global banks have a stronger risk appetite. Following the dollar debt issuance, issuers significantly increase their investment spending but wind up with lower investment efficiency and larger financial vulnerability. Moreover, non-issuers also exhibit increased risk-taking when faced with rising intra-industry competition pressure from issuers. The intra-industry cross-sectional risk distributions are more tilted towards the downside.

The substantial increase in global corporate debt in the past decade revives macro stability concerns of foreign currency liability in emerging countries. Due to data unavailability, there is limited understanding of how the debt proceeds are used. We empirically study the use of proceeds of debt issuance in different currencies using a rich firm-level dataset from Korea which provides information on the currency denomination of both assets and liabilities of firms. We establish six key empirical findings: 1) Consistent with a carry trade hypothesis, firms that issue foreign currency short-term loans increase local currency liquid assets. 2) Consistent with a precautionary saving hypothesis, firms that issue foreign currency loans, regardless of the maturity of loans, increase foreign currency liquid assets. 3) Consistent with the corporate finance pecking order prediction, firms that issue local currency loans reduce both local and foreign currency liquid assets and lower dividend payouts. 4) Investment decreases with short-term foreign currency debt but increases with other types of debt. 5) Stronger carry trade and precautionary saving behavior are observed when the interest rate differential and exchange rate volatility are high, respectively. 6) Sectors that are financially dependent or export exposed have shown a stronger carry trade and precautionary saving behavior.

We study six major “exchange rate puzzles” identified by the literature such as the excess volatility of real exchange rates; their excess reaction to the real interest rate differentials; the uncovered interest rate parity (UIP) puzzle; the excess persistence of real exchange rates; the exchange rate disconnect puzzle; and the consumption correlation puzzle. We examine the behaviour of real exchange rates among pairs of economies that have rigidly fixed nominal exchange rates, e.g. countries within the euro area, regions in China and Canada, and Hong Kong SAR vis-à-vis the United States, compared to that among non-euro-area OECD economies. Our results suggest that some of these puzzles are less “puzzling” under a rigidly fixed exchange rate regime. In particular, real exchange rates appear to have no or little “excess volatility”; the uncovered interest rate parity appears to hold more frequently in these economies; the consumption correlation puzzle largely disappears and we find strong evidence of risk sharing. However, the puzzle of excess real exchange rate reaction to real interest rate differential turns out to be apparently more severe; real exchange rates are as persistent in these economies as in the floating-rate economies; the exchange rate disconnect puzzle still remains. These results may have implications for exchange rate modelling.